Has Brexit started the process for hyperinflation in the UK?
Inflation already in the cake – commodities rise
One key to future inflation is the potential for a long term bottom in commodity prices across the board. Gold may be leading the commodity complex up and crude oil has followed, rallying so far from $27 at the dead low to around $50 per barrel. This is a large percentage increase that will find its way into inflation data over coming months in the same way as falling oil prices have kept inflation low in recent years.
The commodities rally in early 2016 happened against a backdrop of articles predicting endless plunges and an end to the oil and mining industries, implicit bailouts of the shale oil complex with the relaxation of mark to market rules and even the potential nationalization of mining companies proposed down the road. The dumping of the key Port Talbot Steel Works in the UK in recent weeks is an excellent real world example - effectively the death of the strategic steel industry in the world's 6th largest economy (down from 5th in 2014). This is the sort of news that often marks the bottom of a commodity bear market and the start of an upswing in prices of “real things.”
Technical analysis of the gold and gold stocks indices seem to indicate that on a historical basis, their bear markets may have been completed. Chart patterns in the HUI Gold Bugs Index for instance have mirrored those of bear markets such as the Dow Jones Industrial Average in 1929-32 and other significant bear market experiences over the past century such as the DJIA in 1907 and 1974 and the Nikkei in 1989-92 and it is now showing a typical aggressive reversal to the upside.
If the rest of the commodities complex goes into any kind of sustained uptrend, it will add some juice to already existing services inflation. In the UK, both the CPI and RPI price indices have ticked up “unexpectedly” - mirroring similar data in the USA. The RPI provides for better comparison with historical data. The real smoking gun is here: US inflation CPI-U data to Feb 2016 shows clearly the 3% year on year unadjusted rises in services prices has been offset by the 20-30% falls in energy commodities. Guess what can happen when the energy commodities rise? Well, a basic calculation from the table linked above would imply that energy has contributed -0.8% to the CPI. Therefore, in the USA, the end of the fall of commodity prices could add 0.8% to their CPI inflation. If energy prices actually rise to Feb 2015 levels, it could add 0.8% to CPI, a +1.6% swing. That could take US CPI over the Fed’s target of 2%. Similar is likely true for the UK, even not counting the fall in sterling.
Currency debasement already in the cake – more inflation
Since the Brexit vote on 23 June, the pound has fallen from around $1.46 to $1.30, a drop of over 10%. This makes British exports more competitive but does the UK have the industrial infrastructure to take advantage of this? It has a huge trade deficit which may mean that its industries are underequipped to increase production quickly if more foreign demand for British goods and services arises. Since the UK has a huge trade deficit with the EU and with the world, prices of imported goods are going to rise due to the fall in the pound and that will make them less competitive and less attractive compared t British made goods and services. However, three decades of trade deficits (practically continuous since 1982) implies that the UK has a systemic problem in providing its own goods and it may mean that imports are still necessary and consumers will have to pay the higher prices for all kinds of imported items from raw commodities and food to finished products. This is a second factor for a rise in CPI inflation in the fairly near term.
Property Fund redemptions panic of July 2016
News has come in the past few days of several large property funds invested in commercial real estate that have had large requests for redemptions and have either closed themselves to further redemptions or discounted the redemption price by a substantial percentage. This has some echoes of the Bear Stearns funds in early 2008 when they became illiquid and basically brought down the company. However, these funds were highly leveraged collateralised debt obligations (CDOs) and the UK property funds are supposed to be directly invested in actual real estate, so the leverage should be very low. It is odd therefore that there should be so many redemptions in such a short time. If these funds become highly discounted, you would think a savvy real estate investor with a long-term view (how about the Donald?) could step in with cash and buy their shares at a substantial discount.
A lady called Debra commented on an article in The Guardian and it was a great comment: “Why would real estate companies run into trouble in the first place? The investment is supposed to be a multiplier of cash flow. So, if their investments are fully occupied (GOOD BUSINESS with sound tenants) there should not be a problem. However, speculative undeveloped properties will present a MAJOR PROBLEM. It all comes down to good management.”
It would be interesting to know what percentage of these commercial real estate portfolios is in London. I suspect it is a high figure. I once worked for a small, private chartered surveyor company that used to buy residential rental properties for clients large and small as part of its business in 2011-2012. During that time, some of our clients didn't even want to hear of any properties that were not within 50 miles of London and some did not even consider anything at all outside London. One client in particular could be seen selling thousands of properties in more depressed provincial areas, houses that it may have bought during the pre-2008 housing bubble - a time when I guess they would buy “anything.” That must have led to overall under-performance of house prices in these areas post-2008 and made it difficult for other owners to sell. I wonder if a similar thing is now going to hit London - at last. The thing that caught me about Debra’s comment was that I not considered the possibility of speculative undeveloped properties existing in these portfolios. That would likely add a lot to the illiquidity. I suppose any investor needs to look closely at the balance sheets of these individual funds to look at their quality of assets - but they should have done that before they bought units in the fund!
Property market crash
This event of a flurry of fund redemptions in commercial real estate investment funds leading to rapid selling of assets at a discount and freezing of some fund redemptions is a real world test of whether the London property market is a bubble or not. If it is, it may collapse.
Its effect on the banking system is probably unknowable at this point but there is a hint of the possibility of contagion, since for instance Virgin Money shares crashed more than 40% in the few days following the referendum result. No wonder Richard Branson looks like such a desperate man, trying to reverse the result of the vote! I just saw an interview on the Guardian website where he was looking rather agitated and, to use a phrase coined by a work colleague years ago, “sweating like Gary Glitter in Mothercare.”
Rocket Fuel on the Inflationary Fires - Carney says Interest Rate Cuts may be imminent
Mark Carney at the Bank of England has already promised the likelihood of a UK interest rate cut over the summer, hinting that it could be temporary in his language but not saying it explicitly. Reducing capital requirements to encourage lending is another measure and there is also the possibility of more Quantitative Easing. Meanwhile, Jane Yellen has once again stalled and failed to raise interest rates in the USA. The previously “expected” four 0.25% rate increases for 2016 is now down to zero. Both of these events are inflationary in nature. Let’s see who wins in the tug of war between asset deflation and monetary inflation.
Carney says more Quantitative Easing may come soon from Bank of England
Caney at the BoE has hinted at more Quantitative Easing. Meanwhile, Jane Yellen has once again stalled and failed to raise interest rates in the USA. The previously “expected” four 0.25% rate increases for 2016 is now down to zero. Both of these events are inflationary in nature. Let’s see who wins in the tug of war between asset deflation and monetary inflation.
QE and Cutting interest rates into inflation is a driver for more inflation - unprecedented recklessness?
This is a very different situation from 2008. Then, there had been a massive bubble in real estate, stock prices and commodities, including and especially energy commodities such as crude oil. Real estate markets topped and turned down sharply, followed by stock markets and finally commodities, oil being the last to go.
However, in 2016 we have had a severe bear market in commodities with the West Texas Intermediate Crude (WTIC) oil contract hitting $27 at the turn of the year, 75% down from its 2014 high of $107 and 82% down from its summer 2008 high of $147. Now the commodity markets are flattening out and some have turned up sharply at the start of 2016, notably gold, silver and crude oil, with WTIC oil hitting $50 recently. If this is an uptrend, it is going to add significantly to retail price inflation at the same time as there is a danger that real estate asset prices and related stocks and shares such as those of property funds and banks are in serious trouble.
Bank of England may be trapped completely between property asset deflation and commodity inflation
In order to support asset prices, central banks are likely to be forced to cut interest rates, backstop loans and do more Quantitative Easing. These coming at a time when commodity prices may be at the end of a bear market and starting a new bull market is a potential recipe for an explosive rise in the rate of consumer price inflation (CPI).
Rising CPI while interest rates are actually falling will mean that real interest rates” i.e. the interest rate minus the rate of inflation will become sharply negative and this is likely one of the major causes of the aggressive rallies in gold, silver and their related mining shares. There is a well known relationship where negative real interest rates make it less attractive to own cash in a bank account than to own gold in your portfolio. This might be a recipe for the resumption of the precious metal bull markets after four years of underperformance based on previous economic arguments that have now turned 180 degrees in the past 7 months and may now be defunct. It seems ever less likely that interest rates will rise as fast as inflation or even rise at all – in fact they are looking more likely to be cut to try to protect the real estate market.
Hyperinflation assured?
My educated guess is that the central bankers are now falling thoroughly into the soup. With sticky inflation in the service sector running at 3% in the USA and a potential major percentage rally in commodities from low levels coming soon, this leaves them with no defence against inflation but to raise rates in quick fashion. However, central banks are now going to be cutting rates in the UK leaving rates the same in the USA at best, against a backdrop of highly likely spike in consumer prices.
Money appears to be coming out of bubble assets like London real estate. The Brexit may have popped the London property bubble. What if instead the money goes in the previously beaten up sectors of gold and commodities and momentum starts to build in these markets? The perfect storm begins: consumer price and commodity inflation plus real estate and other debt-based asset deflation against a backdrop of ultra low interest rates and perhaps falling stock markets.
As I mentioned in a previous article, there would be no therapeutic level of interest rates. No rate would satisfy, because to raise it could crash asset markets and to stay flat or cut would allow consumer price inflation to romp ahead. This appears to be worst in the United Kingdom right now. The markets are really starting to turn against the central bankers. Branson’s bank shares fell 40% in the last couple of days after the Brexit vote and meanwhile gold is up 40% in 2016.
Conclusion: Maybe the UK is first in the hyperinflation race now
About a couple of years ago, I posted on Korelin Economics Report that I thought that the hyperinflation would probably start in the Eurozone, when everyone else was writing that Japan was going to be the one. My idea was based on the idea that hyperinflation is a currency event, a repudiation of a country’s currency and that was more likely to happen in an area where the very reason for existence of that currency i.e. the Euro) is coming into question.
If that happened, the grand irony would be that hyperinflation would happen in Germany next after they have ‘done their best’ to be seen to use tight monetary policy over recent decades, haunted by the memory of great Weimar inflation of 1923.
Now I wonder if the UK Sterling zone will be first to go into hyperinflation because we in the UK have:
1. Commodity prices already turning up,
2. Big fall in the GB pound sterling after Brexit,
3. Promise from Mark Carney at Bank of England that he may well cut interest rates from 0.50% to 0.25% soon, maybe in July,
4. Promise from BoE that there might be more quantitative easing (QE) in the UK,
5. Commercial real estate property funds stopping redemptions.
This will be the first time I can find where a central bank cut rates into rising inflation. Inflation is currently under the 2% target as it is in the USA but any moment now I think it will jump over 2%. Watch this space.
There is the possibility of a real estate collapse at the same time as rising consumer prices. Wow! Assets down, cost of living up. A perfect recipe for poverty going forward. The perfect storm indeed and the cue for QE to nearly infinity as prices of essentials go to infinity and real estate does not. If it cascades, then watch out for hyperinflation on the horizon. It could happen quickly.
Copyright © David Bellamy 2016.
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